DSE: ‘If it looks too good to be true…’

Special correspondent John Swainston delivers PhotoCounter readers a fact-rich, insider’s take on the Dick Smith debacle, which we believe is better-researched and more objective than the ‘hindsight-wise’ musings of the financial pages’ media fanboys:

John Swainston stepped down from his role as managing director of Maxwell International after a 44 year career in thr photo industry in 2015

John Swainston last year stepped down from his role as managing director of Maxwell International after a 44-year career in the photo industry.

The collapse into Administration and Receivership of Dick Smith Holdings Limited and several associated entities on Tuesday January 5, is a repeat of a story of failed retailers in consumer electronics around the world. We have heard it many times before. But as is the case in many corporate failures, the warning signs were there for anyone who cared to ask even basic questions, or read the public documents. They were there in the prospectus. They were there in the Annual Report in August, 2015. They were there in October and November, just a few weeks ago.

The November 2013 prospectus, underwritten by no lesser corporate luminaries than Goldman Sachs and Macquarie, detailed how the business, acquired from Woolworths for effectively $94 million by Anchorage Capital Partners, was now worth $2.20 a share for a total market capitalisation of $520.3 million.

Many are blaming Anchorage Capital, headed up by ex-Macquarie Bank ‘turnaround specialist’, Phillip Cave. Private equity makes its money by buying cheap, trimming hard, and selling at the top. In the case of Dick Smith, ‘Mission Accomplished.’ Yes not pretty, but having re-read the prospectus, nothing really misleading there. Just very carefully worded! The promoters (Anchorage Capital and directors of the DS Holdings Ltd entity) duly identified multiple risks of consumer preference changes, supply chain, currency and much more, as any prospectus is obliged to do. By the letter of the corporations law, their texts are faultless. Society will decide if it was morally transparent. The most accurate and prescient risk identified was this, found in Section 6.2.4 on Page 79 of the 160-page document from November 2013.

‘If Dick Smith misjudges customer preferences or fails to convert market trends into appealing product offerings on a timely basis, these may result in lower revenue and margins and could adversely impact Dick Smith’s future financial performance. In addition, any change in customer preferences may lead to increased obsolete inventory risk.’

So the promoters clearly understood the issues, specifically stating at the start of that section 6.2.4:
‘Dick Smith’s revenues are almost entirely generated from consumer electronics related products…’ – The shareholders who bought, if they had read this and understood its weighted importance, might have thought twice.

The only winners in te sagas are Phil Cave and his colleagues at Anchorage Partners, who parlayed an initial $10 into a $520 million float a15 months later.

Fabulous: The only winners in the saga are Phil Cave and his colleagues at Anchorage Partners, who parlayed an initial $15 million cash investment into a $520 million float just 15 months later!

But once the business was away, trading as a publicly-listed enterprise, Anchorage became just shareholders. Big ones, mind you. That understanding led, as it now appears, to a clear decision once the August 2014 Annual Report was out. Confidence in the continued value of their shareholdings after the float had clearly waned. Those risks had become clearer from actual operational results. Remember the company was floated after just a few weeks actual trading under the new structure. All the forecasts were pro-forma. There was no history of actual comparable results offered.

Anchorage took until just September 16, 2014, (9.5 months since launch, 30 days after that first ‘Annual’ Report), to unload their remaining 47 million shares at $2.23 a share, just $0.3 cents above float price. A debate as to whether promoters should be forced to hold shares longer is a separate matter. So, despite Statutory EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation) of $43.9 million, the effective negative cash flow had been around $16 million in just 7.5 months. Payables in that first year had increased $119 million, or over 80 percent, as the company started to rebuild inventory. But much of that was on new extended trading terms.

Whispers started around the local industry-supplier corridors. In meetings with Dick Smith in which as an executive of Maxwell International I was either directly or indirectly involved (and as a minor supplier at best) significant increases were demanded in both discounts and payment terms. That was on top of Woolworths’ major intensification of pressure the prior year.

DSE pulled out of photo processing in 2012, and photo product supplers seem ledss exposed than mainstream CE suppluiers to the current disaster.

DSE pulled out of photo processing in 2012, and has shrunk its photo counters in the post-Woolworths era, so photo product suppliers seem less exposed than mainstream CE suppliers to the current disaster.

In my own company’s case most of this was rejected, and promised orders didn’t come as a result. However other suppliers acceded. This was gradually reflected in public documents showing extended payment and improved GP. The die was cast.

These improved trading terms, it now appears, were then used to significantly fund private label stock – funded by the very suppliers’ money with which this Dick Smith private label stock would now compete! As is often the case, higher GP rates for retailers seem instantly attractive. But it’s the appeal of the product to the consumer that counts. And it didn’t. Or not enough.

In the Annual Report for 2015 stock holdings were reported at $293 million as of June 30. COGS (Cost of Goods Sold) were $993 million. So, stock turns were down to just 3.38 turns. That’s a terrible figure for any retail business. In consumer electronics it’s death. The annual accounts suggested to anyone who runs a retail or wholesale CE business that stock was some $70 – $90 million in trouble at June balance date. That assumes stock turns of a modest 4.25 turns a year would have been acceptable. For most retailers I know in this game, 6+ is their goal. And it wasn’t just timing. But the directors took until November 30 before they took a stock write-down of 20 percent, or some $60 million.

By then more Dick Smith private label stock was on its way. And it would most likely have been paid for before it was shipped from Asia. This further impacted cash flow. Those payments to local suppliers were now becoming due, or overdue. Because sales were not there, payments to local suppliers were not all paid on time. So supplies started getting held back. More whispers. The right stuff was not in store any more. It became the death spiral of retail. Sales were falling short of plan.

'Twas indeed!

‘Twas indeed!

The cash drain of $60 million from investment costs, tax payments and dividends of 65 percent of earnings (a shareholder dividend was paid as late as September 30), plus the catch-up of now having to pay for goods deferred earlier through one-time trading terms advantages, forced a rapid draw-down on bank facilities. That draw-down rate appears to have been $75 million in the year to June 2015, and a further $50 million in just six months, from the figures available in the public domain.

By Christmas two weeks ago, it was clear sales promises from management had not been achieved. A week later on New Year’s Eve. management’s focus on growth and private label had failed. At this point non-bank creditors might be as high as $250 million, up from the $230 million in June. With the banks refusing to add to their unsecured exposure, it was time for some phone calls by directors to accounting firms. The rise and fall of Dick Smith Holdings was at hand.

It was over.

The equity at June 30 was reported to be $160 million. Combining the $60 million stock write-down and the effect of slower sales on reduced profitability, even earnings had flipped from $46 million positive for a year to some $70 million+ negative for six months. After writing down stock by $60 million in November and failing to move anything like enough of the $230 million of existing June 30 stock, they simply ran out of bandwidth, even while making a trading profit. As the old saying goes, you can go broke very easily making a profit if you have negative cash flow. And that’s what happened.

The broader issue of dressing up the balance sheet for the float will no doubt be subject to legal investigation by ASIC and possibly other bodies. So I won’t add to the conjecture. The rest of the media has had a field day already. There’s been a feeding frenzy of indignant, wise-after-the-event scribes.

But the facts are these: Woolworths had failed to make a trade sale after 15 months of trying during 2011 and 2012. The Dick Smith division was eventually sold to private equity – after over $420 million of impairment in Woolworths 2011-2012 accounts – for just $15 million. A later performance payment of a further $79 million or so made that $94 million. It stretches credulity that a turnaround of such a claimed fundamental nature had enhanced its value by a factor of 5 in just 15 months, but $520 million is what the Dick Smith float harvested from both retail and institutional investors.

You, the reader, would know that the CE category has been subject to price decline throughout all this time of about 15 percent a year. So if inventory had grown, as it had, by over 100 percent in the first 14 months as a public entity, then annual impairments should have been made and recorded of at least $15-18 million annually since the float. Nowhere do any of the accounts show that. Over three years there was therefore most likely $45 million of unrecorded degradation of value that the November ‘non-cash’ impairment appears not to have covered. This was a miss by management, and by the Board.

12299261_10153352590361298_5236886328788701886_nThe Directors, only some of who had retail experience, started catching up. They acted appropriately in October and again in November and in calling in Administrators. But they believed their management for too long. And now, as Receivers try to work out the full list of creditors and real liabilities, let alone the worth of the inventory and lease exposures and the like, it would be hard to see the business having any continuing viability. Dick Smith’s costs of doing business is some 450 basis points higher than JB HiFi, the industry leader. The business has none of the diversity of Harvey Norman, or its resilience from having over $2 billion in property holdings, as well as a solid (even if as some perceive, old-fashioned) management. But Harvey Norman is a management that has weathered multiple storms as well as some of its own major inopportune investments and come out remaining strong, viable and most important, relevant.

It would seem there are few potential buyers; Dick Smith and its hapless 3300 employees will most likely be gone. Some hard-working suppliers may be taken down by this, or at least massively weakened. Dick Smith will be added to the list of Australian CE brands now departed: Palings, Brashs, Clive Peeters, Clive Anthony’s, Digital City, Megamart, Wow Sight & Sound, – to name but a few. The long-anticipated arrival of Amazon, which has disrupted the European and US retail CE businesses, has yet to occur. It will only get tougher.

A $420 million impairment charge for Woolworths in 2012, a $515 million loss of equity to current shareholders, and some $380 million profit for Anchorage Capital is the wash-up. It’s not pretty, but it’s the reality. Manage cash and your offer to the public, and everything else will fall into place as a retailer. Dick Smith managed neither well: Anchorage did – brilliantly, much as one hates to admit it.

This article was prepared exclusively for Photo Counter Australia, based on publicly available data from investor documents published by Dick Smith Holdings, Anchorage Capital and Woolworths Ltd. © Copyright John Swainston, 2016.


18 thoughts on “DSE: ‘If it looks too good to be true…’

  1. The Dick Smith saga illustrates the very great danger of House Brands. Chasing additional profit with often inferior merchandise is not a strategy for long term survival.

    • Oh I don’t know, I seem to recall a certain wholesaler in the 80’s selling SLR kits with “house brand” Astron lenses, Achiever Flashguns and Pro-Am gadget bags, they’re still around I believe ! Something tells me Aldi aren’t exactly going broke with their Bauhn branded products either. So house brand isn’t exactly new or revolutionary, it’s how it’s run and if you market products that people actually want to buy isn’t it ?
      As for Dick Smith himself, well what can you say. The man who built the whole business on cheap Taiwanese junk marked up to the heavens is now moaning about cheap imports destroying his locally made food business, go figure ?

  2. Stellar article, worthy of the Fin Review.

    I agree with Malcom’s assessment, and perhaps to add that more room out there in the retail space will be pleasant for many.

    Disappointing thought because there is a Dick Smith around every corner, and taking this convenience away may push people further on line.

  3. I find it interesting that much of the media discussion has been on house brands and the Anchorage windfall. Very little (if any) has been on their basic consumer proposition which appeared to be purely promotion based, especially online, which was a sale literally every day.

    • Peter, the flaw was exactly that. Financial projections made on the incorrect consumer proposition that demand would be just as strong for housebrand merchandise (at ultra high margins) as it would for the brands that lead and create the category. The consumer proposition for their product offering and a distinct position that a consumer could understand, and then embrace, was not there. “House brand will rise to 15% of sales within 2016, lifting Gross Margins” was the key emphasis – financial goals above something a consumer would get excited about. Brands build categories, and much more importantly, sustain them through constant innovation and development, not copying and in some cases passing off as ‘the same or similar.”

  4. In THE AUSTRALIAN newspaper today (9th Jan 2016) the writer Andrew White adds a very important further analysis of the Dick Smith inventory value swing. He points out that much of the opening inventory of the new entity after the float may well have been residual stocks from the $400M charge made by Woolworths, and that may, by implication, already have been aged stock in November 2013. This inventory trail is probably the major area in which some criticism of Anchorage capital’s disclosure could be found wanting.
    Given we know that during Anchorage Capital Partners’ ownership a significant run-down in stocks had been achieved, the real value of that opening stock could have been largey the stuff that hadn’t sold since they paid $15M to Woolworths.
    Lesson to the stockmarket and investors: A float for a company not offering a history of trading might in future be required to provide guidance on aged inventory – ie 40% less than 3 months old, 50% between 3 and 6 months old and 10% more than 6 months old.
    Lesson for business owners thinking of putting their privately held business up for sale: Stock and debtors play a big part in the cash value of the business when you sell. Taking a look at aged inventory now in this quieter period of the year might make for some sobering reading. Do something about it now and improve your liquidity before replacing Christmas stocks. And if you don’t know how to quickly calculate aging of stock, then talk to your accountant soon! I did not pick up this factor in my analysis adequately and Andrew White’s piece does a really good job of identifying this matter without the emotion of most other commentators.

  5. I stopped shopping at DSE a couple of years ago when they tightened up their return policy (it’s not often that I’d return things but I don’t shop at places that deliberately make returns hard)

    That’s several thousand dollars I’ve now spent elsewhere

  6. As always a great article thanks John.
    Your points around stock turn vs margin show that there is a lesson here for us retailers in DSE demise.
    After reading some other blogs on this saga, I’ve come across a new measure (new for me) of GMROI. DSE have shown that the pursuit of margin alone with their in-house brand has a detrimental effect if stock turn is not also considered.
    This business measure is worth looking into if you’re not familiar with it. It’s changed my thinking a little.
    Have a look at this for more info http://ganador.com.au/retailsmart/2010/2/28/gmroii-principles-and-calculations.html

  7. Just for the record -Astron was an international brand sold in Japan. Australia , UK and USA. Achiever was sold by Achiever HK throughout the world, it was never a house brand. We made Pro-Am so famous that a number of attempts were made to ride on its coat tails.

  8. I am not familiar with there Dick Smith house brands but here in Canada we have large retailers who sell house brands as a premium product. Sears have a line of tools under the Craftsman label which are consider to be among the best in their category. Another example is the Loblaws chain of grocery stores who put the name “Presidents Choice” on all their premium brand products. As it relates to the photo market we carry the Promaster brand which we have found to be of much higher quality than previous house brands. It is my belief that our supplier of Promaster works very hard to source quality first and best price second. The added bonus is that we enjoy the higher margin on Promaster. As a camera specialty store I don’t think we would have success selling our staff on an inferior house brand product but they took to the Promaster line very quickly when they discovered it was a “premium” accessory line. In other words, I don’t think it’s fair to suggest that “off brands” cannot be a success story for the retailer and the customer.

    • The lesson of Dick Smith is that if you rely on House Brands you will go broke -period.

      The consumers are not mugs.

      • We, McBain Camera, have been in business for over 66 years and we have always carried a house brand as an alternative for the consumer. I believe it is best to give customers a choice.

        • It seems that the Australian consumer is more savvy than his Canadian cousin. We only have 82 years experience in the photo industry.

  9. Same story as that which led to most of the previous CE Retail implosions – competing with their own branded suppliers. Brashs and Vox Group spring to mind!

  10. Whilst all the financial facts have been presented, and none better than this article, the business practices of the Dick Smith exec need to be examined. Insisting that back-to-back rebates accompany any purchase order (rebates that are then banked as revenue) is fraud. ASIC needs to have a look at this…

    • DSE has not bank rebates as revenue since 2004. Prior to that they had no clean way to track the purchase rebate back to the product that was bought, until I wrote the programs for them to keep the rebate in the balance sheet until the goods were sold. What did happen however is that some of the staff were instructed to book the rebates as a reduction in Cost of Goods Sold (making the margins look higher).

  11. The real lesson to be learned here is that there are basically only two reasons why the owners of a business would want to float it: (1) they need a large cash injection to enable investment in something that will expand the business even further, or (2) the owners want to cash out. In the former they often offer the shares at a small discount to fair value to encourage participation, in the latter it is always a “pump & dump”. Anchorage always said they intended to “turn it around and sell it”, why is anyone surprised? To my mind the writing was on the wall *before* they bought it.

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